Valuation of Bonds

What is Bond ?
 A bond is a debt instrument whereby an investor lends
money to an entity (such as a company or a government) that
borrows the funds for a defined period of time at a fixed
interest rate.
 A bond is a security that obligates the issuer to make
specified interest and principal payments to the holder on
specified dates.
• Coupon rate
• Face value (or par)
• Maturity (or term)
 Bonds are sometimes called fixed income securities.
 What’s in a Bond? It is a certificate
containing the following information
Company Name of
Name company/indi
Face value of vidual the
the bond bond has
been issued
to
The interest Repayment
rate to be or maturity
charged date of the
bond
 Security Valuation

 General Model of Valuation

The intrinsic value of an asset = the present value of the
stream of expected cash flows discounted at an appropriate
required rate of return.
0 1 2 n
r
...
Value CF1 CF2 CFn
CF1 CF2 CFn
Value    ... 
(1  r)1 (1  r) 2 (1  r) n
Can the intrinsic value of an asset differ from the market value?
YES
 Bond valuation

 The value of a bond (or any asset) equals the present

value of its expected cash flows.
 The cash flows from a bond are the periodic interest
payments to the bondholder and the repayment of
principal at maturity.
 Therefore, the value of a bond is the present value of the
semiannual interest payments plus the present value of
the principal payment.
 Bond valuation

 The value of bonds can be described in terms of

monetary values or the rates of return they promise
under some set of assumptions.
 There are two models of bond valuation. These are:
 The present value model – which computes a
specific value for the bond using a single discount
value, and
 The yield model – which computes the promised rate
of return based on the bond’s current price and a set
of assumptions.
Bond Valuation
The present-value model
Annual coupon payments
n
Ct Pp
Pm  t 1 (1  i ) t

(1  i ) n
Semi-annual coupon payments
2n
Ct 2 Pp
Pm   
t 1 (1  i 2 ) t
(1  i 2 ) 2n

Where:
Pm=the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
Pp=the par value of the bond
 Bond Valuation
 Determining the value of a bond requires:
• An estimate of expected cash flows
• An estimate of the required return
 Assumptions:
• The coupon interest rate is fixed for the term of the bond
• The coupon payments are made annually and the next coupon
payment is receivable exactly a year from now
• The bond will be redeemed at par on maturity.
• The bond is non-callable.
 Example 1
Consider a 10 year, 12 % coupon bond with a par value
of birr 1000. Let the required yield on this bond be
13%.
The cash flows for this bond are as follows:
• 10 annual coupon payment of birr 120
• birr 1000 principal repayment 10 years from now

10
$120 $1000
Price   
t 1  1.13  t
 1.13  10

Price  $946.10
Bond Values with Semi-Annual Interest

2n C
M
P 2 
t 1 (1 
r ) (1  r ) 2 n
t
2 2
Since the stream of coupon payment is an ordinary
annuity,
P  C  PIVFA r ,2n  M  PVIFr , 2 n
2 2 2

where,
P  value of bond
2n  number of half yearly periods to maturity
C  semi - annual coupon payment (interest on bond)
2
r  periodic required return for half year period
2
t  time period when the payment is received 1
 Example 2

What is the market price of a U.S. Treasury bond that has a

coupon rate of 9%, a face value of birr1,000 and matures
exactly 10 years from today if the required yield to
maturity is 10% compounded semiannually?

0 6 12 18 24 …... 120 Months

45 45 45 45 45+1000
2*10
$45 $1000
Price   
t 1  1.10/2 2*10
 1.10/2 2*10

Price  $937.69
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 Bond Valuation (contd…)

 To determine the value of a bond at a particular point in

time, we need to know:
• Number of periods remaining until maturity
• The Face Value of the Bond
• The Coupon (Interest)
• The market interest rate for bond with similar
features. (Yield To Maturity – YTM)
 Interest rate required in the market on particular bond
type is called the bond’s YTM or simply YIELD of the
bond.
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 Bond Yields and Prices
The case of coupon bonds

 Suppose you purchase the U.S. Treasury bond

described earlier (Example 2) and immediately
thereafter interest rates fall so that the new yield to
maturity on the bond is 8% compounded semiannually.
What is the bond’s new market price?
 Suppose the interest rises, so that the new yield is 12%
compounded semiannually. What is the market price
now?
 Suppose the interest equals the coupon rate of 9%.
What do you observe?
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 Bonds Yields and Prices

 New Semiannual yield = 8%/ 2 = 4%

 What is the price of the bond if the yield to

maturity is 8% compounded semiannually?
2*10
$45 $1000
Price   
t 1  1.04  2*10
 1.04  2*10

Price  $1067.95

Note: If the coupon rate > yield, the bond will sell
for a premium.
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 Bonds Yields and Prices

 Similarly:
If r=12%: coupon rate 9% compounded
semiannually, then:
2*10
$45 $1000
Price   
t 1  1.06  2*10
 1.06  2*10

Price  $827.95
Note: If the coupon rate < yield, the bond will
sell for a discount.

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 Bonds Yields and Prices

 Similarly:
If r=9%: coupon rate 9% compounded
semiannually, then:
2*10
$45 $1000
Price   
t 1  1.045  2*10
 1.045  2*10

Price  $1000.00
Note: If the coupon rate = yield, the bond will
sell for par value.

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 Summary:- Relationship Between
Bond Prices and Yields
 Bond prices are inversely related to interest rates
(or yields).
 A bond sells at par only if its coupon rate equals
the required yield.
 A bond sells at a premium if its coupon rate is
above the required yield.
 A bond sells at a discount if its coupon rate is
below the required yield.

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 Bond Yields and Prices

There is an INVERSE RELATIONSHIP between BOND

PRICE and BOND YIELD

Bond Bond
Price Yield

If the required yield INCREASES, price DECREASES

If the required yield DECREASES, price INCREASES

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Bond prices and Yield: Change in YTM vs
maturity variation
 Consider two bonds with 10% annual coupons
with maturities of 5 years and 10 years.
 The yield is 8%
 What are the responses to a 1% yield change?
Yield 5-year bond 10-year bond
8% $1,079.85 $1,134.20 1064.18- 1134.20
9% $1,038.90 $1,064.18 1134.20
% Change -3.79% -6.17% = -6.17%
7% $1,123.01 $1,210.71
1210.71- 1134.20
% Change 4.00% 6.75%
1134.20
Average 3.89% 6.46%
= 6.46%
 The sensitivity of a coupon bond increases with
the maturity
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 Bond Prices and Yields

Bond Price
Longer term bonds are more
sensitive to changes in (yields)
Interest rates than shorter term
bonds.
Premium
Par
Discount

Yield
8% 9% 12%
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 Bond Yields and Prices:
Change in YTM vs Volatility of Coupon Bonds
 Consider the following two bonds:
• Both have a maturity of 5 years
• Both have yield of 8%
• First has 6% coupon, other has 10% coupon, compounded
annually.
 Then, what are the price sensitivities of these bonds to a 1%
increase (decrease) in bond yields?
Yield 6%-Bond 10%-Bond
8% $920.15 $1,079.85
9% $883.31 $1,038.90
% Change -4.00% -3.79%
7% $959.00 $1,123.01
% Change 4.22% 4.00%
 Average
Lesser coupon rate bonds4.11% 3.89%
are more sensitive to change in yield.

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What Determines Interest Rates

 Inverse relationship with bond prices

 Forecasting interest rates
 Fundamental determinants of interest rates
i = RFR + I + RP
where:
» RFR = real risk-free rate of interest
» I = expected rate of inflation
» RP = risk premium

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 What Determines Interest Rates
 Effect of economic factors
» real growth rate
» tightness or ease of capital market
» expected inflation
» or supply and demand of loanable funds
 Impact of bond characteristics
» credit quality
» term to maturity
» indenture provisions
» foreign bond risk including exchange rate risk and
country risk

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 Bond values over time
 At maturity, the value of any bond must equal its
par value (assuming that there’s no risk of default)
 A bond that is redeemable for birr 1,000 (which is
its par value) after 5 years when it matures, will
have a price of birr 1,000 at maturity, no matter
what the current price is.
 If r (yield) remains constant:
» The value of a premium bond would decrease over time,
until it reached birr1,000.
» The value of a discount bond would increase over time,
until it reached birr1,000.
» A value of a par bond stays at birr1,000.
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 The price path of a bond
 What would happen to the value of this bond if its
required rate of return remained at 10%, or at 13%,
or at 7% until maturity? Assume Coupon is 10%
P

1,372 r = 7%.
1,211
r = 10%.
1,000
837
775 r = 13%.
Years
to Maturity
30 25 20 15 10 5 0
Remaining period to maturity 2
 2. Bond Valuation: The Yield Model

 Instead of determining the value of a bond in monetary

terms, investors often price bonds in terms of yields—the
promised rates of return on bonds under certain
assumptions.
 Thus far, we have used cash flows (interest + face value)
and our required rate of return to compute an estimated
value for the bond.
 To compute an expected yield, we use the current market
price (Pm) and the expected cash flows to compute the
expected yield on the bond.

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 2. Bond Valuation: The Yield Model

Mathematically:
YTM of a bond is the interest rate that makes the present
value of the cash flows receivable from owning the bond
equal to the price of the bond.
 There are two approaches to calculating the yield to
maturity
a. Present-value model
 More involved, more accurate
b. Approximate promised yield
 Easy, less accurate
c. Interpolation approach (Trial and error)
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 2. Bond Valuation: The Yield Model…..
a. The Present value model
 To calculate the yield, we still use the PV model or
equation but it is assumed that we know the price of
the bond and we compute the discount rate (yield) that
will give us the current market price (Pm) as shown
below
2n
Ci 2 Pp
Pm   
t 1 (1  i 2 ) t
(1  i 2 ) 2n

Where:
i = the discount rate that will discount the cash flows to equal the
current market price of the bond
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YTM Example can use scientific calculator
Suppose we paid $898.90 for a $1,000 par 10% coupon bond
with 8 years to maturity and semi-annual coupon payments.
What is our yield to maturity? Can also use trial and error

Period/YR = 2
N = 16
PV = 898.90
Coupon per period = 50
FV = 1000
898.90 = 50 (PVIFA r, 16 ) + 1000 (PVIF r, 16 )
Solution:
r %= 12% 2
 An Approximation

Pp  Pm
Ci 
APY  n
Pp  Pm
2

Exercise
Consider birr1,000 par value bond, carrying a coupon rate of
9%, maturing after 8 years. The bond is currently selling for
birr 800. What is YTM on this bond ? The YTM is the value
of r in the following equation:
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 Using approximate formula

90  (1000  800)
YTM  8  12.78%
(1000  800) / 2
 The YTM calculation considers the current
coupon income as well as the capital gain or
loss the investor will realize by holding the
bond to maturity. In addition, it takes into
account the timing of the cash flows.
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 2. Bond Valuation: The Yield Model…..

Conclusion
 If the computed promised bond yield is equal to
or greater than your required rate of return, you
should buy the bond;
 if the computed promised yield is less than your
required rate of return, you should not buy the
bond and you should sell it if you own it.

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 YTM for Zero Coupon Bonds

No coupon interest payments. The bond

holder’s return is determined entirely by the
price discount.
Suppose you pay $508 for a bond that has 10 years left
to maturity. What is your yield to maturity?

$508 $1000

0 10
PV = FV (PVIF r, n )
508 = 1000 (PVIF r, 10 )
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Zero Example (contd…)

Period /Yr = 1
N = 10
P = 508
FV = 1000
Solution:
r% per year = 7%

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 Valuing Zero Coupon Bonds
What is the current market price of a U.S. Treasury
strip that matures in exactly 5 years and has a face
value of $1,000. The yield to maturity is r=7.5%.

1000
5  $696.56
1.075
What is the yield to maturity on a U.S. Treasury strip
that pays $1,000 in exactly 7 years and is currently
selling for $591.11? 1+r = (1000/591.11)^1/7
0.143
1000 1+r = 1.691733^
591.11  7 1+r = 1.078
(1 r) R = 7.8%
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 Default risk

 If an issuer defaults, investors receive less than the

promised return. Therefore, the expected return on
corporate and municipal bonds is less than the
promised return.

 Influenced by the issuer’s financial strength and the

terms of the bond contract.

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 Other factors affecting default risk
 Earnings stability
 Regulatory environment
 Potential labor problems
 Accounting policies

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 Bond Covenants
Protective Covenants
 The part of indenture or loan agreement that limits certain
actions a company might otherwise wish to take during the
term of the loan.
 Classified into two types:
1. Negative Covenants
2. Positive Covenants (affirmative)
 A negative covenant is a “thou shalt not” type of covenant.
 A positive covenant is “thou shalt” type of covenant.

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 Examples of Negative Covenants

 The firm must limit the amount of dividends it pays

according to some formula.
 The firm cannot pledge any assets to other lenders.
 The firm cannot merge with another firm.
 The firm cannot sell or lease any major assets
without approval of the lender.
 The firm cannot issue additional long-term debt.

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 Examples of Positive Covenants

 The company must maintain its working capital at or

above some specified minimum level.
 The company must periodically furnish audited
financial statements to the lender.
 The firm must maintain any collateral or security in
good condition.

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End of presentation